Wednesday, February 22, 2012

On a recent visit to the Los Altos History Museum with my daughters, I found myself hoping that one day they will appreciate my favorite exhibit: a replica of the wheel-of-fortune used by the Los Altos Land Company in the 1930s. During the Great Depression, the company had a difficult time selling plots in the sparsely-populated apricot orchards that later became Los Altos. That land is now part of the Silicon Valley and among the 100 wealthiest communities in the country, but nobody could have predicted that success back then. To offload the property, the struggling company conducted a promotional contest that took place in San Francisco movie theaters. Participants could spin the wheel to win free stuff, including a choice between a set of dishes and a plot of land in Los Altos. A plot of land was about the price of a set of dishes back in the day and according to the exhibit, most people chose the dishes.

What determined this choice? Economic utility theory tells us that the choice between land and dishes is determined by the marginal rate of substitution between them. However, without more information about the consumer, we cannot deduce the winner’s utility function from owning one more set of dishes or one more plot of land by simply knowing that the prices are equal.Asset pricing theory—an economic theory that attempts to understand the prices of uncertain payments—can give us more insight into the matter. Land and dishes are assets with different properties. Although both could be viewed as durable goods, the set of dishes qualifies as a consumer good, whereas land is largely treated as investment. This allows us to view this scenario as the choice between consumption and investment (or saving); a decision between the two is determined by the relative prices of the two goods, the utility of the consumption good, future returns on investment, and the rate of future discounting (or the degree of impatience). Even without assumptions about the impatience and preferences for fancy dishes, the seemingly naïve choice of the dishes was fully rational given that investment in farm land did not promise great returns at the time.

Now suppose that the lottery winners knew that in 40 years the area’s booming economy would lead to skyrocketing land prices. As a rational economist, if I was a winner at such an event, would I choose dishes or land? My first reaction is: “Of course in this case, I would pick the land!” On the second thought, however, I realize that there is a very good chance that I still would choose the dishes. In troubled times like the Great Depression, both the perception of risk and the demand for liquidity increased, making the dishes a clear winner. Because a set of dishes could be considered a durable good, it could serve as an asset functioning as a store of value. Also, it is easier and less costly to sell or exchange dishes than a plot of land, thus making dishes a more liquid asset than land. Thus simply knowing in 1931 that the Los Altos land would appreciate in a few decades does not imply that it could be immediately converted into cash when needed. In tough economic times, survival today is often more important than planning for the future. Therefore, I would likely choose in favor of current consumption despite the high expected return on investment.

Discussion questions:

1. What piece of information about the dishes and the plot of land is critical in my decision-making?

2. Suppose that land is as liquid as the dishes. How would this affect the choice between the land and the dishes?

3. Would the same economic reasoning apply if it were a dinner instead of the dinnerware?

4. What would be your choice today if you were presented with a similar set of alternatives? Justify why this choice is the same as or different from most people’s choice for dishes in the 1930s.

Tuesday, February 07, 2012

A famous quip suggests that if you could teach a parrot to say "supply and demand," he could replace 90% of the world's economists. However, what economics is really about is analyzing the decisions people make in the face of scarcity and uncertainty. While the supply-and-demand model does have a wide variety of applications, it also comes with a laundry list of assumptions that give the model its power and tractability. One of these assumptions is complete information about the prices and quality of various goods. But one thing is for sure—in the housing market, there is certainly imperfect information about current and future market conditions.

For example, last week I found myself in an interesting predicament while house hunting. I was faced with two options: I could make an offer on a house currently on the market (going forward we’ll call this House A), with the belief that it was priced-to-sell and thus would likely be unavailable in the coming weeks. Or I could wait a month for more houses to come on the market, thus foregoing House A and incurring additional costs, like the effort to find new houses on the market and travel time to look at houses. This situation is exactly the type of scenario studied by search theory economists.

Search theory is a branch of economics that models markets with search frictions. In this case, “frictions” are the unknowns about what kinds of houses will come on the market in the coming months. You are faced with the choice of either accepting the good you’ve found today (House A) or throwing that choice away and paying a cost to find another choice tomorrow (House B). With some standard assumptions regarding utility and the distribution of houses on the market, the optimal way to shop is to use a reservation strategy; this means that you continue to shop until you find a house that makes you equally or more happy than that of the “reservation house”. This is the house that makes you exactly indifferent between continuing to search and buying it.

Thus, you can imagine my excitement surrounding house hunting. Not only is it fun to peruse the web and schedule showings, but house hunting is a great example of where supply and demand falls short, making room for more appropriate economic models like search theory. In most cases, consumers don’t know with certainty where goods can be found, how much they cost, and if they’re available; rather, they must spend time and money searching for these goods. When people ask me what kind of economics I like to study, my typical response is “the economics of shopping.” Search theory is simply the economic tool I use to describe it.

Discussion Questions:

1. How would you expect the time you have to search for houses to factor into the characteristics of your reservation house? In other words, do you think your level of pickiness will change if you had 3 months left to search versus 12 months?

2. Suppose that you didn’t have to worry about losing a housing option if you decide to search another day. Search theorists called this having “recall” over previous draws. How do you think this affects your “reservation house” if you’re searching over an infinite time period. How about a finite time period such as 12 months?

3. How has the internet alleviated search frictions in the housing market?

4. What other markets might be better explained using search theory as opposed to the standard theory of supply and demand? Why?